Analysing India’s monetary policy from a historical perspective

Michael Debabrata Patra of IMF and Muneesh Kapur have written this fascinating paper on the topic.  

A New Keynesian model estimated for India yields valuable insights. Aggregate demand reacts to interest rate changes with a lag of at least three quarters, with inflation taking seven quarters to respond. Inflation is inertial and persistent when it sets in, irrespective of the source. Exchange rate pass-through to domestic inflation is low. Inflation turns out to be the dominant focus of monetary policy, accompanied by a strong commitment to the stabilization of output. Recent policy actions have raised the effective policy rate, but the estimated neutral policy rate suggests some further tightening to normalize the policy stance.  

Apart from the finding mentioned in the abstract, the paper has a superb discussion on regime shift in India’s monetary policy. It divides India mon pol framework in 3 phases.
Phase 1 was upto 1970s when Keynesian thoughts ruled. In this RBI was into  credit rationing and exchange controls

The monetary policy framework in India has undergone fundamental modifications. Surprisingly for an economy that has been inward-looking and relatively closed for the greater part of its independent history, these shifts have mirrored and closely followed the train of global developments. Viewed in a historical perspective, three broad phases of transformation are discernible. First, the period up to the 1970s, with the Keynesian paradigm the ruling orthodoxy worldwide, was marked by subordination to fiscal policy – monetary policy did not matter. As in other developing economies emerging from a colonial past, the logical operational corollary of this regime in India was a structuralist tradition of credit rationing and exchange controls. The pursuit of low unemployment (read as faster growth in developing countries) allowed inflation to drift upwards until it became unconscionable. 

 In phase 2 as stagflation surfaced, Friedman took over. RBI along with other central banks adopted monetary targeting.

The recognition brought on by influential work in the 1960s that monetary policy has powerful effects on real variables in the short run, the shift to floating exchange rates in advanced economies (managed floats in the case of India and many developing economies) and loss of formal constraints on money creation, oil price hikes and stagflation on the back of productivity growth slowdown in the 1970s brought about the end of an era.  

Monetarists assembled international evidence on the association between long-run sustained inflation and excessive money growth. This was bolstered by econometric proof of the stability of the demand for money and the persuasive argument that a central bank could exercise sufficient control over money through its monopoly over currency and reserves. In India, systematic evidence was turned in on stability in money demand and the money multiplier, and a predictable chain of causation running from changes in money supply to prices and output. This ushered in the second phase of monetary policy setting.  

Beginning in the mid-1980s, monetary targeting with feedback became the raison d’être of the conduct of monetary policy in India. Again, viewed with the hindsight of history, it was part of a worldwide revolution. Although Germany (1975), Switzerland (1978) and the USA (the early 1980s) were amongst the first advanced economies to adopt monetary targets in the operating framework of monetary policy, many developing countries also adopted various formulations of the money rule. 

 In third phase as monetary aggregates became difficult to monitor, central banks started conducting mon pol using interest rates. Some moved to inflation targeting. RBI moved to multiple indicator approach.

Yet, winds of change were blowing across the world again. Recession in the early 1980s focused attention on the sacrifice of output/employment that demand managed inflation control entailed. Doubts about the credibility and time consistency of monetary policy surfaced. Moreover, money demand functions, especially in the major advanced economies, started to exhibit instability. Globalization, capital mobile on a massive scale, and the explosion of financial innovations rapidly threatened the edifice of monetary targeting regimes. Accordingly, in the 1980s, several countries either modified the operating framework of monetary policy to a monetary-cum-output targeting approach or abandoned monetary targeting altogether. From 1989, inflation targeting regimes enshrining variants of the interest rate regimen had been gaining currency and several emerging economies also moved to target inflation in an explicit, formal manner.

During this period, ground was being broken again in the academia. Ideas that prices are mark-ups over costs, that there is a natural rate of unemployment, that inflation is influenced by output relative to its potential, and that prices and wages are sticky were getting increasingly established. The door was opened to the analysis of interest rates in the context of practical policy making. Short-term interest rates based on an underlying continuity of influence over the long-term rate and interest rate rules moved into centre-stage of the debate. In 1994, another revolution occurred – the Federal Reserve shed monetary mystique and began to announce the federal funds target, followed by ‘forward guidance’ on its expected path.

India was not immune to these forces. Radical changes occurred in the institutional setting for monetary policy in the 1990s. Notable among them were the phased emergence out of fiscal dominance, a market-based exchange rate regime, the progressive rollback of exchange control, and financial sector reforms resulting in the deregulation of interest rates and the activation of various segments of the financial market continuum. In the late 1990s, the third regime change was set in motion – interest rates progressively became the main instrument of monetary policy, supported by indirect instruments such as open market operations and reserve requirements. The centerpiece in the operating framework of monetary policy became the Liquidity Adjustment Facility (LAF). Repo and reverse repo rates essentially began to provide a corridor for market interest rates to evolve.

 Now, New Keynesian models have been highly criticised in this crisis. (Again the problem is not with the model but their creators who project any model as knows it all). So the paper has a nice discussion of how different models etc fought for survival of the fittest.

Since the 1990s, there has been a marked introspection among central banks about the way in which they conduct monetary policy. Increasingly, they have been willing to abandon secrecy and be more explicit to the public about their actions and the considerations upon which they are based. In some cases, this has been reflected in commitment to straightforward objectives – inflation targeting, for example – but more generally, they have been more forthcoming in their reports and analyses about their goals and why they chose them, the logic guiding their policies and the manner in which they intend to achieve their stated objectives.

Practical application conditioned by (i) a core set of agreed macroeconomic principles about the impact of monetary policy and (ii) a clear political-economic demand for an increased emphasis on policy rules has emerged since the late 1980s and the early 1990s (Taylor, 1998). An illustration of (i) is that while there is no long-run trade-off between output and inflation, there is a short-run trade off that concerns monetary policy. A reflection of (ii) is the wider recognition that people’s expectations matter and the policy rule must be consistent, simple, and systematic and clearly communicated to be able to gauge these expectations.

What is the New Keynesian Model?

Alternatively termed as the New Neoclassical Synthesis or the New Keynesian model, it has emerged as one of the most influential and prolific areas of research in macroeconomics (Gali, 2008a). In one sentence, inflation and output respond to aggregate demand, aggregate demand to interest rates, and interest rates are set by monetary policy, in turn, in response to expected movements in inflation and output. Importantly, money has no explicit role – a model without ‘em’. Within the new Keynesian tradition, however, this paper is agnostic. The fact that money does not make an explicit appearance does not imply any belief that money does not matter. Far from it: money is central but unseen.

Questions on the model remaining, the paper is nevertheless very interesting as it talks about so many things about India’ s monetary policy.